Treasuries: Priced For Disaster

Anxiety levels are rising and Treasury yields are falling. The pairing isn't unrelated, but the depth of the fall in government yields is astounding nonetheless.

The benchmark 10-year Treasury Note’s yield is hovering just over the 2% mark, near all-time lows. As recently as early July, it was over 3%. There’s no mystery here. The crowd is anxious about the macro outlook and so the rush to safe harbors is on.

The extraordinary bull market in bonds, Treasuries in particular, has tripped up more than a few analysts over the past year. Indeed, there’s been no shortage of warnings that bonds were in a bubble and set to crash any day now. That forecast will eventually prove accurate, perhaps sooner than we think. But betting against Treasuries has been a losing proposition thus far.

Along the way, relationships between the major asset classes have moved to extremes. Consider how rolling three-year annualized returns compare for stocks (NYSEARCA:SPY), bonds (Barclays Aggregate), REITS (MSCI REIT) and commodities (NYSEARCA:DJCI). The relatively steady, positive performance in fixed income looks like nirvana in recent history (see the blue line in the chart below - click to enlarge).

The power of bonds appears especially potent when ranked on Sharpe ratio vs. stocks, REITs and commodities. As the second chart below reminds, the risk-adjusted performance for bonds has defied expectations (and gravity).

The diversification value of holding bonds has soared as well, as the third chart suggests. Correlations for REITs and commodities relative to U.S. equities has trended higher in recent years. By contrast, correlations are low and falling for bonds relative to stocks.

In short, bonds are hot, mostly because of Treasuries. It’s unclear how much longer fixed income can shine in relative and absolute terms. But trends continue…until they don’t. The time to think about the dark side is when the light burns brightest. The gravy train in Treasuries may yet roll on, but it can’t last forever. Another global economic calamity might extend the rally, but it takes an especially dark view of the future to rationalize overweighting Treasuries. But what happens if we survive?